View From the Top

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: Risk-on remains the story for now. The combined promise of Central Bank and Government stimulus seems currently to be working, as evidenced by improving economic data and corporate earnings. However, expectations appear cautious, possibly too much so in the very near-term. A V-shaped recovery is, of course, by no means guaranteed and the virus remains a highly significant risk. Low growth, low rates and an uninspiring macro backdrop could be the enduring broad themes with which investors will have to live for some time to come. To generate returns anywhere close to historic levels is therefore going to require more creative thinking. We have counselled diversification for some time. The current environment also calls for a barbell approach towards asset allocation. Truly active and differentiated strategies should prosper.

Asset Allocation:

• Equities: After the strongest quarter for global equities since 2009 and given the continued equity market rally into July, the MSCI World is now only down slightly (<2%) year-to-date. The valuation argument for equities relative to government bonds remains compelling, while the current earnings season is generally surprising to the upside, albeit against low expectations. However, there remain major disparities in markets across both sectors and geographies (tech and the US are outperforming). While these trends may continue for some time longer, we continue to strongly advocate active investment strategies, with clear opportunities available in European, Japanese and emerging equity markets too.
• Fixed Income: With more than 60% of the global government bond market yielding less than 1% and over 85% yielding less than 2% (per ICE Data Services), it is hard to see where the opportunities lie to make money in conventional fixed income markets. That yields are so low is indicative of an expectation for prolonged Central Bank support and hence further supply of fixed income issuance. Correspondingly, investors are being pushed into riskier segments of the fixed income market, such as high yield. We believe it is important to remain highly selective and favour limited exposure.
• FX: The ~10% decline in the value of the US Dollar Index since the start of the year looks like a trend that could continue for some time longer. In particular, there is a good case for prolonged Euro strength relative to the Dollar, given progress in the Eurozone regarding fiscal stimulus combined with US electoral uncertainty ahead of November.
• Gold: All roads continue to lead to gold, in our view. Not only is a weaker Dollar positive for gold, but the asset remains a compelling hedge against cyclical factors, stagflation (a plausible future combination of low growth and inflation) and rising geopolitical tensions. Listed gold miners represent another potential opportunity.
• Alternative Assets: We see a clear role for such assets in portfolios. Low yields generally strengthen the case for private assets. Those with strong balance sheets in non-cyclical sectors (e.g. seniors’ housing or logistics REITS) should continue to prosper. We see selected opportunities in infrastructure, real estate and niche private equity.

Summer vibes

Summer is generally associated with warmer weather, holidays and relaxation; a break from reality, if you like. Maybe this is a valid analogy for how many participants are regarding financial markets. Sceptics assert that fundamentals are becoming increasingly divorced from reality, whereas bulls would stress that now is the time to be making hay while the sun shines. We have been very much in the latter camp, arguing that sentiment towards many riskier asset classes remains too cautious. The main challenge, of course, for all investors – and indeed holidaymakers – remains the COVID-19 virus; it’s stubbornly refusing to disappear and a vaccine remains some way off. Ultimately, how long the broadly warm vibes endure in financial markets will be a function of whether investors believe policymakers or the virus will get the upper hand. One potentially more eloquent way of solving this conundrum is simply to take the view – and one we are sympathetic towards – that much of the short-term is just noise. Rather, our counsel remains one of looking at the bigger picture and focusing on the longer-term opportunities.

One thing is clear: equity markets around most of the world have been rising despite an increasing number of people diagnosed with (and suffering from) the virus. Indeed, “the worst is yet to come”, per the World Health Organisation. Perhaps investors are simply looking through COVID-19 in the near-term? Some of the moves are also likely being driven by a so-called FOMO (fear of missing out) stampede. At the least, we appear currently to be in the ‘hope’ phase of the recovery; an expectation that things should improve. However, hope is not a strategy. September – the anticipated return date to office work/school for many in the northern hemisphere, which will be accompanied by colder weather (and higher trading volumes in financial markets) – may herald a stronger dose of reality; or, if not reality, then possibly mean reversion.

The bulls are certainly in the ascendency at present, helped by the substantial monetary and fiscal support being provided by governments globally. Central Banks, for now, continue to run the show. Some $13tr of new money will have been created cumulatively by the Federal Reserve, European Central Bank, Bank of England and Bank of Japan by year-end, per Morgan Stanley. Additionally, fiscal policy is beginning to play an increasingly important role, not just in the US, but crucially in Europe too. The importance of the announcement in July of a €750bn stimulus package by the European Union should not be under-estimated; it may presage stronger union and certainly more coordinated and robust fiscal policy going forward.

Crucially, broad stimulus appears to be having the required effect too. The latest survey readings of manufacturing and services indices are now showing reports of over 50 in both the US and Europe, pointing to economic expansion (in April, these figures had reached lows of around 40 and 30 respectively). Meanwhile, although only around one third of companies on both sides of the Atlantic have reported results for the calendar second quarter earnings season, both sales and earnings have generally surprised to the upside, albeit against a backdrop of low expectations.

However, a V-shaped recovery is by no means guaranteed. Just 14% of respondents in the latest Bank of America Merrill Lynch Fund Manager survey foresee such an outcome (with 44% predicting a ‘U’, 30% a ‘W’ and the balance unsure). The bald reality remains that the only way to bring activity back to pre-crisis levels is to convince consumers that the virus is no longer a risk. We are not epidemiologists, but successful vaccine development and implementation could prove challenging, particularly as the virus continues to mutate. As far as consumers are concerned, it is interesting to note that the savings ratio in both the US and Europe is currently at its highest level in at least a decade. And what of the 17m+ people still claiming unemployment benefit in the US? Some 42% of layoffs may result in permanent job losses, per the National Bureau of Economic Research.

Consider Japan as a window into one possible future. In a country with challenged demographics, the young are growing up in a stagnant economy with a debt-burdened government. Against this background, their first instinct is to save. Low growth, low rates and an uninspiring macro could be enduring themes for some time to come. For western policymakers, this playbook is at least worthy of serious contemplation, particularly with debt levels currently rising. Globally, debt levels are set to increase by $16tr in 2020, taking combined public and private borrowing past $200tr for the first time over the course of this year (per JP Morgan). Non-financial corporate debt in the US stands at a record 49% of GDP. Similarly, loans in the Eurozone to non-financial corporations are at their highest since the financial crisis. Meanwhile, bankruptcies in the US are at their highest in a decade (all data per Jefferies).

Given the above dynamics, it is hard to ignore a scenario of widening inequalities; and one that is taking place more broadly against a backdrop of rising international tensions. Thought of another way, the pandemic hasn’t so much changed the world as brought into sharp relief the flaws, deficiencies and disrepair of both the national and international order. Consider how some combination of civil unrest, young urban populations and poverty could be potentially explosive in many geographies across the developing and developed world.

Furthermore, there exists the not unfair view that more government intervention may imply the risk of increased capital misallocation and therefore market inefficiencies. This was certainly the economic orthodoxy for much of the post-war period, at least until the time of the financial crisis. What seems clear is that policy (both fiscal and monetary) is becoming more politicised; consider modern monetary theory as a case in point. There may well then be unintended consequences from current policy actions; the creation of new problems for the future. Of course, none of the above may matter in the very-near term, at least for as long as FOMO remains the order of the day, but at some stage, these issues will undoubtedly need to be addressed.

Postscript: What about the US Election?

Most surveys currently suggest that the presumptive Democrat candidate, Joe Biden, has a ~10 percentage-point lead over the incumbent, Donald Trump. However, a lot can change within three months. It also certainly fair to say that Trump’s chances of re-election would improve if the number of confirmed COVID-19 cases falls. More broadly, we are also deeply wary of trying to infer causality from political events. On many counts the Trump Presidency has been a disaster – at least in terms of America’s standing internationally – but most risky assets have rallied throughout his tenure.

The full Biden agenda is still not clear, although it may become more so once his choice of running mate (or de facto Vice President) is confirmed. Do not forget that it is rare that any candidate’s full set of policies gets implemented. History suggests that challengers typically campaign at extremes prior to being elected. The prevailing consensus seems to be that a Democrat victory might be bad for financial markets as it could imply higher taxes and more regulation, particularly for the mega-cap tech companies (which have been driving much of the recent rally). However, the reality may be much more nuanced. Given the current economic backdrop, business recovery and growth are likely to be prioritised. Further, a more diplomatic approach to domestic and foreign policy may result in lower volatility and risk premia. Those vibes we discussed earlier might just endure a little bit longer.

Alex Gunz, Fund Manager, Heptagon Capital